7 April 1991 Income Tax Severed Letter - Deductibility of Interest

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Dear Sirs:

Re: Paragraph 20(1)(c) of the Income Tax Act (the "Act")

This is in reply to your letter of March 13, 1990 wherein you asked for our comments on the deductibility of interest on money borrowed by a corporation to return capital or make other payments to shareholders. We regret the delay in responding to your letter.

As the situations described in your letter involve transactions contemplated by particular taxpayers, we are unable to comment n them specifically. Pending the enactment of the proposed amendments referred to in the Notice of Ways and Means Motion to amend the Act, which was last tabled in the House of Commons on December 20, 1990 (the "Motion"), we are prepared under certain circumstances to issue opinions, rather than advance rulings, on the question of the deductibility of interest on money which a taxpayer proposes to borrow to redeem shares, return capital or pay dividends. Should you wish an in-depth consideration of the proposed transactions referred to in your letter, your request should follow the formal set out in Information Circular 70-6R2 for requesting advance income tax rulings. Although the form of your request does not enable us to comment specifically on the transactions you described, we have set out below our general comments on the issues you have raised. Our general comments assume that the shareholders acquired the various assets after valuation day.

The purpose of the Motion was to extend for another year the current administrative practice of Revenue Canada, Taxation ("RCT") with respect to the deductibility of interest on borrowed money used for the purpose of earning income from a business or property. It stated the intention of the Minister of Finance that, among other thing:

... for the purpose of the rules relating to the deduction of interest on money borrowed before 1992, a definition of the expression "borrowed money used for the purpose of earning income from a business or property" be introduced to include ...

(b) any borrowed money used by
• (i) a corporation to return capital to its shareholders by way of a redemption, acquisition, cancellation of any shares, reduction of capital or otherwise, ...

to the extent that such capital was used by the corporation or partnership for a qualifying purpose; ...

At the 1987 Corporate Management Tax Conference RCT stated:

"Accumulated profits" means accounting profits computed on an unconsolidated basis with investments accounted for on a cost basis. Appraisal surplus and profits resulting from non-arm's length transactions designed to transform appraisal surplus into profits would not form part of accumulated profits. Accumulated profits need not be allocated proportionately among shareholders.

At the 1988 Round Table, RCT stated:

Accumulated profits do not include any appraisal surplus and profits resulting from non-arm's length transactions that transform appraisal surplus into accumulated profits on a non-taxable or tax-deferred basis. For example, a tax-deferred basis may involve a situation in which A Co. transfers an asset to B Co. with which it does not deal at arm's length, receiving as consideration preferred shares, and both file elections under subsection 85(1). While A Co. has a gain for accounting purposes, this gain does not form part of A Co.'s accumulated profits. Should B Co. borrow to redeem the preferred shares, the interest is deductible only to the extent of the paid-up capital of those shares for tax purposes.

The situation contemplated at the 1988 Round Table was one that would have taken place in 1988, where the paid-up capital ("PUC") of the preferred shares, within the meaning of paragraph 89(1)(c) calculated in accordance with the provisions of subsection 85(2.1) and assuming no non-share consideration, was equal to the adjusted cost base of the transferred asset and the amount agreed upon in the election (the "Elected Amount") filed under subsection 85(1). That being the case, the 1988 Round Table position, as it would apply to transfers of property utilizing the provisions of subsection 85(1), reflects our view that the interest on borrowings used to redeem shares issued on a rollover would be deductible under paragraph 20(1)(c) only to the extent that the amount borrowed does not exceed the difference between the Elected Amount and the amount of any non-share consideration received by the shareholder.

Viewed this way, the deductibility of interest on money borrowed to redeem the preferred shares received on a transfer of an asset to a corporation utilizing the provisions of subsection 85(1) is not dependent on whether subsection 85(2.1) applied to reduce the PUC of the shares for tax purposes. Regardless of when the transfer took place, the interest would only be deductible, as stated above, to the extent that the amount borrowed does not exceed the difference between the Elected Amount and the amount of any non-share consideration received by the shareholder (i.e., the amount that is the return of capital used by the corporation for a qualifying purpose within the meaning of clause (1)(b) of the Motion).

If, prior to June 6, 1987, a shareholder exchanged his shares (the "Old Shares") of a target corporation for shares (the "New Shares") of another corporation (the "New Shareholder") having an aggregate redemption amount and stated capital equal to the fair market value of the Old Shares and the rules subsection 85.1(1) were applicable to the exchange, subsection 85.1(2.1) would not apply to reduce the PUC of the New Shares for tax purposes.

The difference between the PUC of the New Shares and the ACB of the Old Shares is not an addition to the PUC of the Old Shares of the target corporation. Therefore, assuming the PUC of the Old Shares represents the amount originally paid by the Old Shareholder, the maximum borrowing which would result in an interest deduction upon a return of capital on the Old Shares would be equal to the amount of the PUC of those shares.

The comments set out in this letter are of a general nature and do not take into account the numerous additional considerations that might arise in the context of specific fact situations. The opinions expressed do not constitute advance income tax rulings and, in accordance with paragraph 22 of Information Circular 70-6R2, are not binding on RCT in respect of any transaction or taxpayer.